Chief Economist Eugenio J. Alemán discusses current economic conditions.
As we start the second half of the year and as we approach next week’s release of the preliminary report on real GDP for the second quarter of the year, we continue to expect second-half economic growth as well as inflation to downshift compared to what we saw during the first half of this year. The ‘long and variable lags’ of monetary policy will continue to put a cap on economic growth as real interest rates, that is nominal interest rates minus inflation, continue to increase and continue to exert downward pressure on economic activity.
Furthermore, this weaker economic growth will continue to help bring inflation down, slowly but surely, to the Federal Reserve’s (Fed’s) target of 2.0% for the Personal Consumption Expenditures (PCE) price index over the long term. That is, paraphrasing Fed Chair Jerome Powell, during an interview earlier this week in which he referenced these ‘long and variable lags’ of monetary policy, he argued that “The implication of that (i.e., long and variable lags) is that if you wait until inflation gets all the way down to two percent, you’ve probably waited too long, because the tightening that you’re doing, or the level of tightness that you have, is still having effects which will probably drive inflation below two percent.”
But what he is really saying is what we have been arguing since the Fed changed its mind during the first quarter of the year regarding interest rates, that is, as inflation continues to fall, real interest rates will continue to tighten monetary policy even if the Fed does not do anything. That is, real interest rates will continue to bite and put downward pressure on economic activity.
After expecting three rate cuts during 2024 earlier this year we have settled on at least two cuts before the end of the year, with the first rate cut coming as early as after the September meeting of the Federal Open Market Committee (FOMC), which is scheduled for September 17-18, with a second one after either the November or the December meeting of the FOMC.
That is, we believe that the ‘search for more confidence’ on the forward path of the disinflationary process by Fed officials is forthcoming and will accelerate with the performance of the economy during the rest of the year. Furthermore, the fact that, as we have argued on several occasions, the disinflationary process has continued unabated even as the U.S. economy has grown at a faster rate than potential output guarantees that as the economy continues to weaken the disinflationary process will strengthen and will give more confidence to Fed officials that it will be okay to start lowering interest rates.
Pay (more) attention to the CPI during the second half of the year
You have read from us over the last several years that we have always given reduced importance to the Consumer Price Index (CPI) compared to the Personal Consumption Expenditures (PCE) price index. The reasons are varied but the most important ones are that housing, or shelter costs, are overweighted in the CPI versus the PCE price index while the PCE price index is the one used by the Fed for conducting monetary policy.
The differences are the same between the two indices but because shelter cost increases have started to weaken, together with the fact that shelter costs are about 35% of the weight in CPI versus a 13% in the PCE price index, it follows that if shelter costs are accelerating, then the CPI tends to rise faster and higher than the PCE price index. However, since now it seems that shelter costs are decelerating, then there is the potential that year-over- year CPI starts falling at a faster pace than the PCE price index.
Since markets and analysts tend to follow the CPI releases rather than the PCE price index releases, it follows that a potential steeper deceleration of the CPI versus the PCE price index during the second half of the year will have the potential to improve market perceptions regarding the disinflationary process going forward, which will further help Fed officials gain more confidence about inflation.
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Opinions are those of Investment Strategy and not necessarily those of Raymond James and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur. Last performance may not be indicative of future results.
Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Statistics. Currencies investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.
Consumer Sentiment is a consumer confidence index published monthly by the University of Michigan. The index is normalized to have a value of 100 in the first quarter of 1966. Each month at least 500 telephone interviews are conducted of a contiguous United States sample.
Personal Consumption Expenditures Price Index (PCE): The PCE is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The change in the PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behavior.
The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.
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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.
The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.
The Conference Board Coincident Economic Index: An index published by the Conference Board that provides a broad-based measurement of current economic conditions.
The Conference Board lagging Economic Index: an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.
The U.S. Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the U.S. dollar gains "strength" when compared to other currencies.
The FHFA House Price Index (FHFA HPI®) is a comprehensive collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.
Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).
ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month. ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.
ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.
ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the U.S. economy from month to month.
ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.
Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time.
Producer Price Index: A producer price index (PPI) is a price index that measures the average changes in prices received by domestic producers for their output.
Industrial production: Industrial production is a measure of output of the industrial sector of the economy. The industrial sector includes manufacturing, mining, and utilities. Although these sectors contribute only a small portion of gross domestic product, they are highly sensitive to interest rates and consumer demand.
The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.
The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index measures the change in the value of the U.S. residential housing market by tracking the purchase prices of single-family homes.
The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan.
Source: FactSet, data as of 7/7/2023
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